Why do fixed-rate cash Isas now offer lower interest than other savings accounts?

I have a relatively modest pot of cash I have built up in an Isa over the last decade and am looking to maximise the £20,000 allowance coming in for the next financial year.

However, I cannot help but notice the large differences between cash Isa rates and accounts that are not tax-free – and it seems like this gap has grown, especially in terms of fixed-rates.

What is the reason for these large differences?Via e-mail.

Suffering: Cash Isa rates have been down in the doldrums for some time now

Lee Boyce, consumer affairs editor for This is Money, replies: There are thousands of cash Isa savers who may be scratching their heads and asking the same question as they come to fill their pots before the end of the tax year, or consider what to do with the £20,000 allowance coming in from 6 April.

Previously, between March and May, there would be a glut of banks and building societies seeking out Isa cash - and it would lead to a battle of best buy rates, dubbed 'Isa season'.

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The top one-year cash Isa rate in the independent This is Money savings tables is 1.2 per cent offered by Newcastle Building Society, compared to 1.6 per cent for a non tax-free deal from Atom Bank - and for a short time, this Atom deal paid an even higher two per cent.

The next highest rate for a one-year cash Isa is 1.05 per cent, compared to 1.62 per cent for a standard account – and this theme continues throughout the rest of the fixed-rate tables.

The best buy two-year cash Isa pays 1.26 per cent interest, three-year 1.4 per cent and five-year 1.75 per cent.

This compares to 1.7 per cent, 2.15 per cent and 2.25 per cent respectively for standard accounts.

This is a substantial gap given that the personal savings allowance, which came into play last April, means basic rate taxpayers can get £1,000 of interest tax-free now, while higher rate taxpayers can make up to £500 in interest without having to pay a penny of tax.

It's not such a similar story for easy-access rates. The top easy-access cash Isa offers just 0.95 per cent, or 1.01 per cent for an account which allows a handful of withdrawals a year.

On a standard easy-access, the best buy rate is 1.1 per cent.

The fixed rates are a bitter pill to swallow for cash Isa savers, who may be coming to the end of a long-term fix which paid a far higher rate than those they can obtain now.

It's true that there has been a little battle in the standard fixed-rate tables in recent months, but this hasn't filtered through to cash Isa deals.

James Blower, independent expert at the Savings Guru, replies: This gap has worsened in the past few months.

There's a gap of between 10 and 50 per cent in pricing. Even excluding Atom Bank, which only accept applications via their mobile app, there's a difference of 10 and 40 per cent.

There are three reasons for this. Firstly, the tax benefit of Isas are 20, 40 or 45 per cent, depending on what rate of personal income tax you pay.

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Simon Healy, managing director of savings at Aldermore Bank, says: Isas are more complex than other saving products and therefore more expensive to design, create, run and manage, which is a factor in the pricing for many providers.

The rules of the scheme dictate there are more responsibilities for a provider compared with standard savings accounts, requiring additional system work, greater processing capacity, additional reporting processes and management oversight.

Examples of responsibilities include accounting and reporting for Isa subscriptions in a given tax year, Isa auditing, and for the likes of the Help-to-Buy Isa scheme, there is the additional requirement of managing special features such as payments to lawyers.

Although taking all this into account an Isa is a hugely beneficial savings vehicle for anyone focusing on long-term savings.

If cash Isas and standard savings accounts paid the same rate, most savers would pick an Isa, especially given the higher allowances that exist now.

Isas are about to allow £20,000 in each financial year. When they only allowed a few thousand in, it was a different story.

Banks don't need to pay so much for Isas as savers are more likely to stick away larger sums, filling their coffers quicker.

Secondly, the low interest rate environment and new personal tax allowance combined mean basic tax rate paying savers will need approximately £50,000 in the top paying one-year taxable account before they are liable for tax and £25,000 in the case of higher rate tax payers.

This has reduced the attractiveness of cash Isas and reduced demand has had a downward impact on pricing in the market - the competition is being driven in the standard fixed-rate savings market, which is where challengers are choosing to compete.

Cash Isas are seeing a net outflow of cash whereas the savings market generally is growing at over five per cent per annum.

Finally, the best rates on savings are typically offered by the newer so called challenger banks.

These banks often start by competing for taxable fixed-rate bonds and then instant/notice savings.

Some go on to offer Isas but many don't. Isas involve more cost to set up for the newer banks and more regulation to administer.

Consequently, there are fewer new banks competing in the market for Isa money so that doesn't help to push the pricing up.

Your reader should certainly consider whether the interest rate differential warrants a switch. The only downside of coming out of the Isa is that the previous years' allowances are then lost forever.

Tom Adams, head of research at website Savings Champion, replies: There are a number of reasons why there is a gap between the top standard fixed-rate deals and cash Isas.

First of all, cash Isas have to allow savers access to the funds, even if there is a penalty, whereas usually fixed-rate bonds will simply not allow access at all.

This means the funds are not certain to stay with the provider for the full term and so, the chances of the funds being withdrawn is taken into account when the interest rate is set.

The second reason is an important one - the rates in the savings market generally and in particular among fixed rate bonds are driven by the challenger banks, who are providing competition in the market and driving best buy rates upwards.

Certainly without them, the savings market over the last few years would have looked a lot worse.

The problem is that many of these challenger banks do not offer cash Isas, so that competition that is crucial in other areas of the market, is lacking.

The introduction of the personal savings allowance in April 2016 has make the decision of whether to open a cash Isa or not, a much more tricky one.

However, especially for taxpayers, cash Isas remain an important part of a saver's arsenal, offering tax-free returns regardless of the balance held in the account.

By utilising the Isa allowance each year, you can build up a significant sum that will remain tax-free regardless of what happens to interest rates, whereas if interest rates rise, the PSA may be utilised far more quickly.

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